Burning down the commodity craze

[8 November 2010 | Ес далан зургаа]

The stock market can seem pretty erratic given the frantic pace of the hourly news-cycle, but it helps to take the long view. Astute investors still remember that ten years ago the global financial market was completely contrary to the current commodity-driven market. In the early 2000s, analysts largely ignored mining stocks under the hype of emerging industries. In 2001, the combined market value for quoted mining and metals companies was $300 billion, half of Microsoft’s market capitalization at the time. Prior to 2004, when commodity prices had been on the bottom side for almost a decade, some large investment institutions did not even have analysts covering mining companies and industrial commodities.

Fast-forward a decade or so, and the market has completely changed. Take the largest miner in the world, BHP Billiton. In less than a decade, its market capitalization grew six-fold, from $29.5 billion in 2001 to $190 billion in 2010. In the last few years, financials and miners have been the biggest gaining sectors in composite indexes around the world. This could be explained by the fact that easy access to capital and technology has vastly increased competition in industries, where technology had once been the source of a substantial profit margin. Adaptable and well connected consumers, along with increased competition, are forcing manufacturers to fiercely compete for a limited supply of raw materials. As a result, profit margins are shifting from manufacturers to resource suppliers.

In 1995, only three mining companies, if refineries are excluded, were listed in “Fortune Global 500”. The 2009 list draws a completely different picture as it has a total of 16 mining companies, excluding oil and gas companies. Driven by the commodities boom, revenues of mining companies have increased more than ten-fold and their profit margins have tripled. In contrast, profit margins for the automotive industry were cut in half in the same period, even though revenue has doubled. Semiconductor manufacturers are facing a similar dilemma: although their revenue has increased six-fold, their profit margins were also halved. Thus, mining companies are outperforming most industries, including the booming electronics industry, where profit margins have only doubled despite nine times growth in revenue.

Nevertheless, it is doubtful whether the explosive growth of the commodity industry can be sustained in the future. Investors often base their commodity price forecasts on various econometric models, some of which are sophisticated enough to take into account the probability of technological advancement and political unrest. These models, along with long-term price movements, point to the cyclical nature of commodity prices: what goes up must come down.

PRICE BOTTOM CYCLE

In theory, when market prices are falling, high cost miners will be forced to close, hence reducing excess supply in the market. However, mining operations tend to stay in operation for 5-10 years or as long as planned (often longer than 10 years) because mining operations require a large initial investment: as costs are sunk, every penny above operating costs translates to a gain for investors. Thus, it may be more profitable for mines to continue operating despite market signals to the contrary. Moreover, the process of closing down or re-opening of a mine is costly and requires a certain length of time. Consequently, participants cannot be easily forced to reduce production in matter of months.

The supply reduction process may also be delayed by the introduction of new mines. Investment in new capacities mostly occurs during a commodities boom, when mining companies have excess capital. According to our limited research, multinational mining companies seem to take approximately 6-10 years from exploration to the extraction phase, thus new mines are likely to become operational during a downturn given the cyclical nature of commodity prices. If there isn’t any apparent demand shock (highly unlikely as statisticians argue that business cycles have a periodicity of 5-11 years: Kitchin cycle and Juglar cycle), it could be assumed that a bottom cycle will continue as long as new capacities are introduced.

PRICE UPWARD CYCLE

During a downturn, most mines operate at a marginal profit over operating costs, and thus will not have the financial liberty to invest in high-risk exploration activities. When demand finally outgrows supply in the market, there will not be enough projects in the pipeline to develop in a matter of months. As a result, it will take at least 6-10 years to develop a new mine. Hence, the supply pressure will persist for a certain period of time barring any demand shocks. It should be noted that when commodity prices are at their height, shareholders will pressure managers to actively invest in new mining projects, and this behavior will further lengthen the next bottom cycle.

Based on the assumptions provided, a careful look at the projected new developments for a particular resource may pinpoint to the next period of excess capacity. The upward cycle that began in 2004 has been persisting for quite some time, and multinational mining companies have been exceptionally profitable. Since the mining industry has had plenty of free cash to develop and acquire new projects, the current phase of demand side pressure is likely to be shortened. For instance, investments that were made in 2004 will reach production phase beginning 2011.

Let’s look at copper. If we assume that global demand for copper will expand by 4% annually, as it has been for the last century, demand for copper is likely to expand by 2 million metric tons by 2013. According to ICSG, copper production was at 15 million metric tons in 2008. By 2013, 3.7 metric tons of new capacities will be introduced.

Although we have focused on a selected number of new projects in our analysis, the supply of copper is likely to outstrip its demand by 2013 at the latest. This in turn should push copper prices into a downward cycle, which is expected to last longer at Bilig Capital as mining companies and investors have been extensively injecting cash in new projects.

Bilig Capital believes that the hype surrounding Mongolia’s Oyu-Tolgoi (OT) project is overdone at every level. First of all, OT’s expected production commencement schedule could coincide with the start of the next price bottom cycle. Moreover, Ivanhoe Mines, which is heavily geared, has a loss carry-forward agreement with the government; thus, it is difficult to envisage a large inflow of cash from OT tax payments to government coffers for the better part of next decade.